Judge the quality of a company's earnings
The idea
Evaluating earnings quality means testing reported profit against cash and against economics. Compute accrual ratios on the balance sheet and cash flow bases and track them over time; compare revenue growth with growth in receivables and deferred revenue. Check whether gross margin improvements came from lower reserves or capitalised costs, and see how much of profit rests on gains or reserve releases. Look at how earnings compare with consensus: repeatedly beating by a small amount can indicate management of estimates. Tie the findings back to management's incentives. The trap is accepting operating profit as defined by management, since non-GAAP figures that exclude recurring costs overstate core earnings.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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- Show how a conceptual framework is used to judge how reliable and useful a company's financial reporting is
- Explain problems that can undermine the quality of financial reports
- Explain the process for judging how good a company's financial reports are
- Judge how good a company's financial reports are
- Explain the signs that indicate earnings quality
- Explain what is meant by sustainable (persistent) earnings
- Explain why earnings revert to the mean and how accruals change how quickly they do so
- Judge the quality of a company's cash flows
- Explain the signs that indicate balance sheet quality
- Judge the quality of a company's balance sheet
- Explain the signs that indicate cash flow quality
- Set out where information about risk can be found